Lesson Two

CORPORATE GOVERNANCE

The question we wish to address is “who is in the best position to make a given decision
about the direction of a company, and does that person or groups have the necessary
authority?

Corporate governance seeks to:

 Find the appropriate mechanisms for governing the relationships of constituent

groups with the company to generate long-term value.
 Reduce conflicts of interest among various stakeholders
 Make sure that the right people make the decision.
 Create and implement internal organization of the company and define more
closely and represent more presently the interest to which management should
respond to and the goals towards which they should strive.
 Ensure that corporate power is exercised in the interests of society.

The focus of corporate governance is on the system by which companies are directed
and controlled.

- Corporate governance is at the heart of corporate success and can have

significant influence on the economic development of a country.
- Effective corporate governance ensures that long-term strategic objectives and
plans are established.
- It ensures that the proper management and management structure are in place to
achieve those objectives.
- It makes sure that the structure functions to maintain the company’s integrity,
reputation, accountability to its relevant constituencies/Stakeholders.
- The right system of checks and balances should be the basis of merit for any
corporate governance system.
 ANGLO-AMERICAN CORPORATE GOVERNANCE STRUCTURE

Shareholders (AGM)

Auditors Directors (BOD)

Senior Management

Employees

1. SHAREHOLDERS

Appoint directors and the auditors and satisfy themselves that an appropriate
governance structure is in place. They are expected to remove directors if unhappy with
their actions.

2. B.O.D

BOD is the link between the people who provide capital (Shareholders) and the people
who use that capital to create the value (Management and Employees). Their primary
role is to monitor and influence the performance of management on behalf of the
shareholders in an informed way.

FUNCTIONS OF B.O.D
 - Governance of the company
- Setting the company strategic objectives and plans
- Providing the leadership to put them into effect.
- Supervising the management of the business
- Creating momentum, movement, improvement, and direction
- Reporting to shareholders on their stewardship
- Representing the interests of the shareholders and those of the society.
Why boards of directors have more than not failed to protect shareholders interests:

Do they effectively oversee the management? Possibly no because of:

- Excessively powerful CEOs

- The culture of the boardroom syndrome
- Conflict of interest for some directors
- Devoting less directors’ time on company business.

3. AUDITORS

Provides the shareholders with an external and objective check on the director’s
financial statements which form basis of their reports to shareholders as to whether the
financial statements show a true and fair view or not.

4. MANAGEMENT

 These comprise the CEO and his senior management team. Primary
responsibility is performance.
 A major challenge addressed by corporate governance is how to grant managers
enormous discretionary power over the conduct of the business while holding
them accountable for the use of that power.
 Balancing the two is essential to ensure that the decisions made by the
management are in the long-term interests of the shareholders (and thus by
definition all other constituencies).
Specific management practices that have been found to improve corporate performance:

1. Three-dimensional strategy comprising exploration of new horizons, selectivity

(the ability to focus on the key imperatives), and drive (a passion for being the
best).
2. Making wisdom contagious, including empowering independence, interaction,
and communication among employees focusing on group performance rather
than individual performance.
 3. External processes, including benchmarking (particularly of marketing systems,
delivery and distribution systems, and service after delivery systems-all relating
to the link between the company and its customers), systems for feedback from
suppliers and customers.
4. Continuous innovation, based on the internal and external evaluations.
Driving forces/factors behind keen interest in corporate governance

 Increasing corporate failures e.g., collapse of sugar factories, financial

institutions; manufacturing concerns Enron case, world com etc.
 Increasing fraudulent and corrupt behavior e.g., money laundering, bribery,
abuse of corporate power etc.- e.g., Goldenberg scandal, bad debt crisis in the
banking sector, fraudulent claims in insurance sector.
 A growing demand by stakeholders for transparency, accountability as the
words embraces wider issues of democratization and good governance. This has
increased shareholders activism.
 Powerful and dominant BOD that manipulates shareholders and other
stakeholders at the firm. The BOD perceives most shareholders as illiterate, and
dot understand fully issues in business sectors.
 Structures that demand academic and professional qualifications e.g., some
boards never demand basic qualifications of the board members. Shareholding
and influence are used as a benchmark to get a seat in the board.
 The growth of multi-nationals and transactional firms.
 The global governance revolution resulting from globalization of firms and
economic liberalization.
 Separation of ownership from control.
Advantages of Good Corporate Governance

 Protection of investors’ rights.

 Enhance corporate performance; capital formation and maximization of
shareholders wealth (promote corporate growth).
 Promote standards of self-regulation.
 Greater investor’s confidence and access to capital.
 Less risk of costly litigation and substantial compensation payout.
 Efficient and responsible use of capital and companies’ resources.
 Greater loyalty from customers and employees.
 Create mechanism that selects, monitors, and replaces managers in a timely
manner.
 Enhanced corporate image and positive reputation.
Corporate governance guidelines issued by Capital Markets Authority (CMA)
  Audit committees
This consists of at least 3 independent non-executive directors who shall report to the
board. The committee has written terms of reference.

 Directors’ remuneration
It should be competitive and comparable to similar firms to retain the best directors.

 Remuneration committee
The board should appoint a committee consisting of independent non-executive
directors with the mandate to recommend to the board a suitable compensation
package.

 Appointments to the board

A formal and transparent system should be used.

 Re-election of directors
Should be held at least annually and not all directors should retire to allow continuity.
board

 Board balance
The composition of the board should be balanced with at least 1/3 of the members as
independent and non-executive directors.

 Information
Information should be on a timely basis to all stakeholders and should be relevant and
accurate.

THE AGENCY THEORY AND PROBLEM ( Meckline and Jesen 1976)

An agency relationship arises where one or more parties called the principal
contracts/hires another called an agent to perform on his behalf some services and then
delegate’s decision-making authority to that hired party (agent). In the field of finance
shareholders are the owners of the firm. However, they cannot manage the firm
because:

a) They may be too many to run a firm.

b) They may not have technical skills and expertise to run the firm.

c) They are geographically dispersed and may not have time.

Shareholders therefore employ managers who will act on their behalf. The managers are
therefore agents while shareholders are principal.

Shareholders contribute capital, which is given to the directors, which they utilize and
at the end of each accounting year render an explanation at the annual general meeting
of how the financial resources were utilized. This is called stewardship accounting.

- In the light of the above shareholders are the principal while the management are
the agent
- Agency problem arises due to the divergence of interest between the principal
and agent. The conflict of interest between management and shareholders is
called agency problem in finance.
- There are various types of agency relationship in finance exemplified as follows:
1. Shareholders and Management

2. Shareholders and Creditors

3. Shareholders and Government

4. Shareholders and Auditors

5. Head office and the Branch/subsidiary.

1. Shareholders and Management

There is near separation of ownership and management of the firm. Owners employ
professionals (managers) who have technical skills and expertise. Managers might take
actions, which are not in the best interest of shareholders. This is usually so when
managers are not the owners of the firm, they don’t have any shareholding. The actions
of the managers which conflict with the interest of their jobs. The actions of the
managers who are in with the shareholders include:

The agency theory explains how to best organize agency relationships

to prevent conflicts and other issues that arise between agents and
principals. There are two key assumptions underlying the agency
theory, and they are:
 1. Individuals are generally egoists who act in their own self-
interests. In short, both the principal and agent are out for their
own benefits.
2. Agents have access to more information and are usually in a
decision-making capacity.

i) Incentive problem

Managers may have fixed salary and they may have no incentive to work hard and
maximize shareholders wealth. This is because irrespective of the profits they make,
their reward is fixed. They will therefore maximize leisure and work less, which is
against the interest of the shareholders.

ii) Consumption of perquisites (PERKS)

Prerequisites refer to the high salaries and generous fringe benefits which the directors
might award themselves. This will constitute directors’ remuneration which will reduce
the dividends paid to the ordinary shareholders. Therefore, the consumption of
perquisites is against the interest of shareholders since it reduces their wealth.

iii) Different Risk-profile (Risk takers, Risk Averse, Risk Neutral)

Shareholders will usually prefer high-risk-high return investments since they hold
diversified investments i.e., they have many investments and the collapse of one firm
may have an insignificant effect on their overall wealth.

Managers on the other hand, will prefer low risk-low return investment since they have
a personal fear of losing their jobs if the projects collapse. (Human capital is not
diversifiable). This difference in risk profile is a source of conflict of interest.

iv) Different Evaluation Horizons

Managers might undertake projects, which are profitable in shot-run. Shareholders on

the other hand evaluate investments in long-run horizons, which is consistent with the
going concern aspect of the firm. The conflict will therefore occur where management
pursue short-term profitability while shareholders prefer long-term profitability.
v) Management Buy Out

The board of directors may attempt to acquire the business of the principal. This is
equivalent to the agent buying the firm, which belongs to the shareholders. This is
inconsistent with the agency relationship and contract between the shareholders and
the managers.

vi) Pursuing power and self-esteem goals

This is called “empire building “to enlarge the through mergers and acquisitions hence
increase in the reward of managers.

vii) Creative Accounting

I.e., use of accounting policies to report high profits e.g., stock valuation methods,
depreciation methods recognizing profits immediately in long-term construction
contracts. etc.

Solution to Shareholders and Management Conflict of Interest

Conflicts between shareholders and management may be resolved as follows:

1. Pegging/attaching managerial compensation to performance

This will involve restructuring the remuneration scheme of the firm in order to enhance
the alignment/harmonization of the interest of the shareholders and the management
e.g., managers may be given commissions bonus etc. for superior performance of the
firm e.g. the employers of Kenya Airways recently were given extra income due to high
profitability of the firm.

2. Threat of firing

This is where there is a possibility of wasting the entire management team by the
shareholders due to poor performance. Management of the companies have been fired
by the shareholders who have the right to hire and fire the top executive office e.g. the
entire management team of Unga Group, IBM, G.M. have been fired by shareholders

3. The Threat of Hostile Takeover

The shares of the firm are undervalued due to the poor performance and
mismanagement. Shareholders can threaten to sell their shares to competitors. In this
case the management team is fired and those who stay on can lose their control and
influence in the new firm. This threat is adequate to give incentive to management to
avoid conflict of interest.

4. Direct Intervention by the Shareholders

Shareholders may intervene in the as follows:

a) Insist on a more independent board of directors.

b) By sponsoring a proposal to be voted at the AGM
c) Making recommendation to the management on how the firm should be run.
5. Managers should have a voluntary code of practice, which would guide them in the
performance of their duties.

6. Executive Share Options Plans

In a share option scheme, selected employees can be given a number of share options
each of which gives the holder the right after a certain date to subscribe shares in the
company at a fixed price.

The value of an option will increase if the company is successful and its share price goes
up. The theory is that this will encourage managers to pursue high NPV strategies and
investments, since they as shareholders will benefit personally from the increase in the
share price that results from such investment.

However, although share option schemes can contribute to the achievement of goal
congruence, there are a number of reasons why the benefits may not be as great as
might be expected, as follows:

i. Managers are protected from the downside risk that is faced by shareholders. If
the share price falls, they do not have to take up the shares and will still receive
their standard remuneration, while shareholders will lose money.
ii. Many other factors as well as the quality of the company’s performance influence
share price movements. If the market is rising strongly, managers will still benefit
from share options, even though the company may have been very successful, the
share price will fall if there is a downward stock market adjustment, and the
managers will not be rewarded for their efforts in the way that was planned.
iii. The scheme may encourage management to adopt ‘creative accounting’ methods
that will distort the reported performance of the company in the service of the
managers’ own ends.

NB: The choice of an appropriate remuneration policy by a company will depend,

among other things on:

i. Cost: the extent to which the package provides value for money
ii. Motivation: the extent to which the package motivates employees both to stay
with the company and to work to their full potential.
iii. Fiscal effects: government tax incentives may promote different types of pay. At
times of wage control and high taxations this can act as an incentive to make the
‘perks’ a more significant part of the package.
iv. Goal congruence: the extent to which the package encourages employees to work
in such a way as to achieve the objectives of the firm-perhaps to maximize rather
than to satisfy.
7. Incurring Agency Cost

Agency costs are incurred by the shareholders in order to monitor the activities of their
agent. The agency costs are broadly classified into three

a) The contracting cost. These are costs incurred in devising the contract between
the managers and shareholders. The contract is drawn to ensure management act
in the best interest of shareholders and the shareholders on the other hand
undertake to compensate the management for their effort.
Examples of the costs are:

-Negotiation fees

- The legal costs of drawing the contracts fees.

- The cost of setting the performance standard, negotiation fees.

b) Monitoring Costs: This is incurred to prevent undesirable managerial actions.

They are meant to ensure that both parties live to the spirit of agency contract.
They ensure that management utilizes the financial resources of the shareholders
without undue transfer to themselves.
Examples are:
 - External audit fees
- Legal compliance expenses e.g. preparation of financial statement according to
international accounting standards, company law, capital market authority
requirement, stock exchange regulations etc.
- Financial reporting and disclose expenses
- Investigation fees especially where the investigation is instituted by the
shareholders.
- Cost of instituting a tight internal control system (ICS).
c) Opportunity Cost/Residual Loss

This is the cost due to the failure of both parties to act optimally e.g. Lost
opportunities due to inability to make fast decisions due to tight internal control
system

Failure to undertake high-risk return project by the manager leads to lost profits
when they undertake low risk, low return projects.

d) Restructuring Costs - e.g. new I.C.S. business process reengineering etc.

2. Shareholders and creditors/bond/debenture holders

Bondholders are providers or lenders of long-term debt capital. They will usually
give debt capital to the firm on the strength of the following factors:

a) The existing asset of the firm

b) The expected asset structure of the firm

c) The existing capital structure or gearing level of the firm

d) The expected capital structure of gearing after borrowing the new debt.

NB:

- In raising capital, the borrowing firm will always issue of the financial securities
in form of debentures, ordinary shares, preference shares, bond etc.
- In case of shareholders and bondholders the agent is the shareholder who should
ensure that the debt capital borrowed is effectively utilized without reduction in
the wealth of the bondholders. The bondholders are the principle whose wealth
is influenced by the value of the bond and the number of the bonds held.
Wealth of bondholders =
 Market value of bonds x No. of bonds/debentures held.

- An agency problem or conflict of interest between the bondholders (principal)

and the shareholders (agents) will arise when the shareholders take action that
will reduce the market value of the bond and by extension, the wealth of the
bondholders. These actions include:
a) Disposal of assets used as collateral for the debt

In this case the bondholder is exposed to more risk because he may not recover, the loan
given in case of liquidation of the firm

b) Assets or investment substitution

In this case, the shareholders and bondholders will agree on a specific low risk project.
However, this project may be substituted with a high-risk project whose cash flows
have high standard deviation. This exposes the bondholders because should the project
collapse, they may not recover all the amount of money lent.

c) Payment of High Dividends

Dividends may be paid from current net profit and the existing retained earnings.
Retained earnings are internal source of finance; the payment of high dividends will
lead to low level of capital and investment thus reduction in the market value of the
share and the bonds.

A firm may also borrow debt capital to finance the payment of dividends from which
no returns are expected. This will reduce the value of the firm and bond.

d) Under Investment

This is where the firm fails to undertake a particular project or fails to invest
money/capital in the entire project if there is expectation that most of the returns from
the project will benefit the bondholders. This will lead to reduction in the value of the
firm and subsequently the value of the bonds.

e) Borrowing more debt capital

A firm may borrow more debt using the same asset as collateral for the new debt. The
value of the old bond or debt will be reduced if the new debt takes a priority on the
collateral incase the firm is liquidated. This exposes the first bondholders/lenders to
more risk.

Solutions to agency problem

The bondholders might take the following actions to protect themselves from the
actions of the shareholders which might dilute the value of the bond. These actions
include:

1. Restriction Bond/Debt Covenant

In this case the debenture holders will impose strict terms and conditions on the
borrower.

These restrictions may involve:

a) No disposal of assets without the permission of the lender.

b) No payment of dividends from retained earning

c) Maintenance of a given level of liquidity indicated by the amount of current assets

in relation to current liabilities.

d) Restrictions on mergers and organizations

e) No borrowing of additional debt, before the current debt is fully serviced/paid.

f) The bondholders may recommend the type of project to be undertaken in relation

to the riskiness of the project.

2. Callability Provisions

These provisions will provide that the borrower will have to pay the debt before the
expiry of the maturity period if there is breach of the terms and conditions of the bond
covenant.

3. Transfer of Assets

- The bondholder or lender may demand the transfer of asset to him on giving debt or
loan to the company. However the borrowing company will retain the possession of the
asset and the right of utilization
- On completion of the payment of the loan, the asset used as collateral will be
transferred back to the borrower

4. Representation

The lender or bondholders may demand to have a representative in the board of

directors of the borrower who will oversee the utilization of the debt capital borrowed
and safeguard the interests of the lender or bondholders.

5. Refuse to lend

If the borrowing company has been involved in un-ethical practices associated with the
debt capital borrowed, the lender may withhold the debt capital hence the borrowing
firm may not meet its investments needs without adequate capital.

The alternative to this is to charge high interest on the borrower as a deterrent

mechanism.

6. Convertibility: On breach of bond covenants, the lender may have the right to
convert the bonds into ordinary shares.

3. Agency relationship between shareholders and the government.

Shareholders and by extension, the company they own operate within the environment
using the chatter or license quoted by the government. The government will expect the
company and by extension its shareholders to operate the business in a manner which is
beneficial to the entire economy and the society.

The government in this agency relationship is the principal while the company is the
agent. It becomes an agent when it has to collect tax on behalf of the government
especially withholding tax and PAYE.

The company also carries on business on behalf of the government because the
government does not have adequate capital resources. It provides a conductive
investment environment for the company and share in the profits of the company in
form of taxes.

The company and its shareholders as agents may take some actions that might
prejudice the position or interest of the government as the principal. These actions
include:
a) Tax evasion: This involves the failure to give the accurate picture of the earnings or
profits of the firm to maximize tax liability.

b) Involvement in illegal activities by the firm.

c) Lukewarm response to social responsibility calls by the government.

d) Lack of adequate interest in the safety of the employees and the products and
services of the company including lack of environmental awareness concerns by the
firm.

e) Avoiding certain types and areas of investment coveted by the government.

Solutions to the agency problem

The government can take the following actions to protect itself and its interests.

1. Incur monitoring costs

E.g. the governments incur costs associated with:

- Statutory audit

- Investigations of companies under Company Act

- Back duty investigation costs to recover tax evaded in the past

- VAT refund audits

2. Lobbying for directorship (representation)

The government can lobby for directorship in companies, which are

deemed to be of strategic nature and importance to the entire economy or
society e.g. directorship in KPLC, Kenya Airways, KCB etc.

3. Offering investment incentives

To encourage investment in given areas and locations, the government

offers investment incentives in form of capital allowances as laid down in
the Second schedule of Cap 470.

4. Legislations
 The government has provided legal framework to govern the operations
of the company and provide protection to certain people in the society e.g.
regulation associated with discloser of information, minimum wages and
salaries, environment protection etc.

5. The government can in calculate the sense and spirit of social

responsibility on the activities of the firm will eventually benefit the firm
in future.

6. Guidelines on minimum disclosure in financial statements.

4. Agency relationship between shareholders and auditors

Shareholders appoint auditors as per the provisions of section 159(1) (6) of the
companies Act. The auditors are supposed to monitor the performance of the
management on behalf of the shareholders. They act as watchdogs to ensure that
the financial statements prepared by the management reflect the true and fair of
the financial performance and the position of the firm. Shareholders are therefore
the principal and auditors the agent. The auditors may prejudice the interest of
the shareholders thus causing agency problems in the following ways:

A) Colluding with the management in performance of their duties whereby

their independence is compromised.

b) Demanding a very high audit fee (which reduces the profits of the firm)
although there is insignificant audit work due to the strong internal
control system existing in the firm.

c) Issuing unqualified reports which might be misleading the shareholders

and the public and which may lead to investment losses if investors rely
on such misleading report to make investment and commercial decisions.

d) Failure to apply professional care and due diligence in performance of

their audit work.

Solutions to the conflict

1. Firing: The auditors may be removed from office by the shareholders at

the AGM.
 2. Legal action: Shareholders can institute legal proceedings against the
auditors who issue misleading reports leading to investment losses.

3. Disciplinary Action – ICPAK.

Professional bodies have disciplinary procedures and measures against

their members who are involved in un-ethical practices. Such disciplinary
actions may involve:

- Suspension of the auditor

- Withdrawal of practicing certificate

- Fines and penalties

- Reprimand

4. Use of audit committees and audit reviews.

5. Head office and subsidiary/branch

- MNC has diverse operations set up in different geographical

locations.

- The HQ acts as the principal and subsidiary as an agent thus

creating an agency relationship.

- The subsidiary management may pursue its own goals hence

causing conflict of interest with the HQ due to sub-optimization.

- This conflict can be resolved in the following ways:

a) Frequent transfer of managers

b) Adopt global strategic planning to ensure commonality of vision

c) Having a voluntary code of ethical practices to guide the branch

managers
d) An elaborate performance reporting system proving a 2-way
feedback mechanism.

e) Performance contracts with managers with commensurate

compensation package for the same.